How can you pay the least interest and get the most tax deduction on your home loan?
This article breaks down the benefits of prepaying your home loan and how it impacts both your interest payments and tax savings.
How can you pay the least interest and get the most tax deduction on your home loan?
Posted on 22 Sep 2024
Author: Sayan Sircar
15 mins read
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This article breaks down the benefits of prepaying your home loan and how it impacts both your interest payments and tax savings.
This article is a part of our detailed article series on the concept of home loans. Ensure you have read the other parts here:
-
How much time and interest do you save if you pay off your home loan using a step-up EMI?
This article shows how quickly you can pay off your home loan, and even save a lot of interest, by increasing your EMI steadily year-on-year.
-
Home loan tax benefits that you get when you buy a property jointly with your spouse
This article tells you why it is a good idea to buy a home jointly as a couple and it is not only the tax benefits you get.
-
Home Loan Eligibility for Joint Applicants: how to buy a bigger house
This article shows you an easy way to calculate how big a house you can buy based on your family’s combined monthly salary.
-
Home Loan Rate Hiked? How Much Prepayment should you make to Keep EMI and Tenor Same?
Home loan rate hike? You can prepay to keep EMI and tenor same. This post shows how.
-
How paying a small fee to your bank can save you lakhs in home-loan interest?
This article shows how paying a small fee to your bank to reduce your home loan rate can save you lakhs in interest over the life of your loan.
-
What benefit do you get if you make a one-time prepayment to your home loan?
This article shows you the benefits due to interest saving when you make a part-payment to your home loan. Your loan duration also reduces due to the pre-payment.
-
How much EMI do I have to pay for my home loan?
This article shows a handy ready reckoner for home loan EMI amounts for all tenures and interest rates along with the amount of principal and interest to be paid.
-
Should you prepay your home loan at the beginning or at the end of the tenure?
This article helps you decide when to prepay your home loan - at the beginning, middle or end of the total loan period.
-
How does an overdraft loan like SBI Maxgain work?
This articles describes overdraft home loans like SBI Maxgain and BOB Home Loan Advantage.
-
What should you do when your home loan interest rates go up?
This post discusses managing when interest rates go up increasing your home loan EMI.
📚 Topics covered:
- How can you pay the least interest and get the most tax deduction on your home loan?
- Which is better: getting more tax deductions or paying less interest?
- What is the benefit of tax deduction available for home loans?
- What happens if you prepay the loan?
- What is the impact on tax savings and interest paid if you prepay the loan?
- What should you do with a lump sum amount?
How can you pay the least interest and get the most tax deduction on your home loan?
There is only one lever to pull when paying off a home loan to reduce the interest you pay and the tax deduction you receive. This lever is the amount you decide to prepay at any time to pay off the loan more quickly.
There is nothing else you can do regarding the home loan since:
- You obviously cannot stop paying the EMI (you would be declared a defaulter and lose the house).
- You cannot lower the EMI (same reason as above).
- Everything else (such as step-up EMI, part payment, etc.) are forms of prepayment.
Related:
How to manage a home loan if you are worried about job loss?
Which is better: getting more tax deductions or paying less interest?
The right answer is Neither.
The best thing to do, when paying off your home loan, is to choose a prepayment plan that maximises the Net Present Value of your net loan cash flows: How Net Present Value (NPV) Can Help You Make Smarter Financial Decisions
Net Cash Flow = EMI + Prepayment - Tax Savings
Net Present Value = NPV( rate, [ -loan amount , net cash flows …] )
🤖 Explainer: What is Net Present Value?
The net present value or net present worth is a way of measuring the value of an asset that has cash flow by adding up the present value of all the future cash flows that asset will generate. (Wikipedia)
We will now try to explain a few bits intuitively without mathematics.
If the NPV discount rate is equal to the loan rate, NPV = 0
For convenience, we set the NPV discount rate (minimal acceptable rate of return) equal to the loan interest rate. This result holds because the EMI is calculated at the same rate as the loan rate, giving a zero NPV.
After-tax loan rate = Loan rate * (1 - marginal tax rate)
| Loan rate | New tax regime | 10% slab | 20% slab | 30% slab |
|---|---|---|---|---|
| 7.00% | 7.00% | 6.30% | 5.60% | 4.90% |
| 7.25% | 7.25% | 6.53% | 5.80% | 5.08% |
| 7.50% | 7.50% | 6.75% | 6.00% | 5.25% |
| 7.75% | 7.75% | 6.98% | 6.20% | 5.43% |
| 8.00% | 8.00% | 7.20% | 6.40% | 5.60% |
| 8.25% | 8.25% | 7.43% | 6.60% | 5.78% |
| 8.50% | 8.50% | 7.65% | 6.80% | 5.95% |
| 8.75% | 8.75% | 7.88% | 7.00% | 6.13% |
| 9.00% | 9.00% | 8.10% | 7.20% | 6.30% |
| 9.25% | 9.25% | 8.33% | 7.40% | 6.48% |
| 9.50% | 9.50% | 8.55% | 7.60% | 6.65% |
| 9.75% | 9.75% | 8.78% | 7.80% | 6.83% |
| 10.00% | 10.00% | 9.00% | 8.00% | 7.00% |
Some investors may prefer to set the discount rate equal to the after-tax rate of the loan due to the tax deduction on interest, as per the table above.
Related:
Should you prepay your home loan at the beginning or at the end of the tenure?
What is the benefit of tax deduction available for home loans?
If you are in the old tax regime, you can deduct up to ₹200,000/year of home loan interest from your taxable income. This way, depending on your tax slab, you can get tax savings per financial year as follows:
| Tax bracket | Tax Savings upto |
|---|---|
| 0% | 0 |
| 10% | ₹20,000 |
| 20% | ₹40,000 |
| 30% | ₹60,000 |
| New tax regime | 0 |
Related: Which is the best tax regime: old or new?
Since the discount rate used in NPV is the same as the loan rate, any tax savings during the repayment period give a positive NPV. This NPV cannot increase further unless the borrower moves into a higher tax bracket during the loan’s lifetime.
Therefore, any prepayment will only reduce the NPV of the loan.
What happens if you prepay the loan?
When you prepay a loan:
- You permanently save interest on the amount prepaid for the remaining tenure of the loan.
- The prepaid amount no longer provides utility since it is not being spent or invested.
- The prepaid amount is gone from your pocket permanently and will not come back (unless you have an overdraft loan).
- The total tax benefit you receive also reduces since the overall interest paid is lower.
The NPV calculation lets us know whether prepayment is beneficial based on these rules:
- If you have nothing better to do with that money (e.g. invest it).
- If you fear a loss of income due to job loss or illness.
- If you receive a windfall (e.g. via RSUs, a rallying small-cap stock, or an inheritance).
- If you value the peace of mind that comes from becoming loan-free sooner.
What is the impact on tax savings and interest paid if you prepay the loan?
The Arthgyaan goal-based investing calculator shows you this impact on interest paid and tax savings due to loan prepayment. We have a tab “loan-prepayment” that allows you to see these changes.
We will use Google sheets to create a simple calculator for this calculation. There is a link to download a pre-filled copy of the Google sheet via the button below.
Important: You must be logged into your Google Account on a laptop/desktop (and not on a phone) to access the sheet.
We will assume an outstanding loan balance of ₹1 crore borrowed for 15 years at 9%. The calculator allows you to calculate the total tax deduction for up to four borrowers on the loan, each with their tax rate. If any borrower is on the new tax regime, you can set their tax rate to zero which effectively zeroes out any tax benefits on the home loan.
Base Case - no prepayments
Case 1 - one prepayment
Here we make a single ₹10 lakhs prepayment in the secord year.
Case 2 - regular prepayments
Here we make ten one lakh prepayments in the first ten years of the loan.
Summary of the three cases
| Calculation | Base Case | Case 1 | Case 2 |
|---|---|---|---|
| Total tax saved | 12,97,863 | 10,27,227 | 11,11,934 |
| Total interest paid | 86,08,832 | 67,29,562 | 73,61,792 |
| Net Present Value | 7,21,988 | 6,16,072 | 6,54,620 |
Here it is interesting to see that paying smaller regular amounts via prepayment is better than one large prepayment at the beginning. This is due to time value of money and that ₹10 lakhs at the beginning of the loan does not earn a lot of interest outside the loan. The second case pays more interest but has a higher NPV.
You can use the calculator with various prepayment values and see which numbers you like to have. At the end of the day, it is not a case of simple prepayment but a case of investing a lump-sum amount in the loan or in your portfolio. We explain how to do that below.
What should you do with a lump sum amount?
Whenever you have some extra money available that you are not spending:
- Refer to your financial plan to know where the amount can go next.
- Decide if you should invest the amount into long-term, mid-term, or short-term investments.
- Only if your financial plan suggests short- or medium-term goals, should repayment be considered a valid option.
We extend the concept of the bucket theory of portfolio construction to create a framework to be used in the accumulation, i.e. the pre-retirement stage when the investor has active income and is investing for future goals.
The Arthgyaan Have vs Needs framework (HvN) is a simple tool to tell you how much money you need to invest:
- for all of your financial goals
- which asset class should you invest in next
We will now break this down in simple terms. There are two important questions that investors who are investing for their goals ask:
- how much more money do I need for my goals?
- where the next rupee of investment should go into
The Arthgyaan HvN framework needs you to make a very 4x4 simple table with three asset class buckets and for each bucket asks you to calculate three numbers: the amount you already have (the HAVE column), the amount you need to reach your goals (the NEED column) and the difference between the two (the GAP column).
The three buckets are:
- equity bucket for long-term goals while beating inflation
- debt bucket to either generate income or provide stability vs the equity bucket
- cash bucket for spending on short-term goals
The columns are:
- HAVE is the total market value (at today’s prices) for the assets you own. For example, if you have 5 lakhs invested in an equity mutual fund, and as the latest NAV, the value of these funds is 8 lakhs then the value of the HAVE column is 8
- NEED is the present value of all of the goals. We will show how to calculate this
- GAP = NEED - HAVE and is the amount you need to grow your portfolio by to consider your goals to be funded
We also have a TOTALs row to give a high-level view of the portfolio.
You can follow the complete guide here: How to invest a lump sum amount for your goals?.
Related Articles
- What benefit do you get if you make a one-time prepayment to your home loan?
- Home Loan Rate Hiked? How Much Prepayment should you make to Keep EMI and Tenor Same?
- Should you prepay your home loan at the beginning or at the end of the tenure?
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